Question

Tawana owns and operates a sole proprietorship and has a 40 percent marginal tax rate. She provides her son, Jonathon, $15,000 a year for college expenses. Jonathon works as a pizza delivery person every fall, and has a marginal tax rate of 15 percent. 1.What could Tawana do to reduce her family tax burden? a..Employ her son in her sole proprietorship b.Ask Jonathon to find a new job c. Start a new enterprise 2.How much pretax income does it currently take Tawana to generate the $15,000 after taxes given to Jonathon 3.If Jonathon worked for his mother’s sole proprietorship, what salary would she have to pay him to generate $15,000 after taxes (ignoring any Social Security, Medicare, or self-employment tax issues)? (Round your answer to the nearest whole dollar amount.) 4.How much money would this strategy save? (Round your intermediate calculations and final answers to the nearest whole dollar amount.) This strategy will save tawana_____pretax and will save the family_____after tax.

Answer 1

1. Family’s tax burden can be reduced by employing her son in her sole proprietorship, thereby shifting income taxed at 40 percent (Tawana’s marginal tax rate) to 15 percent (Jonathon’s tax rate) .

2.Tawana $25000 of pretax income to generate the $15000 after-taxes given to Jonathon

After-tax income = Pre-tax income x (1 – marginal tax rate)

$15000 = Pretax income x (1 – .40)

Pretax income = $15,000 / (.60) = $25000.

c.If Jonathon worked for Tawana’s sole proprietorship, she would only have to pay him $17,647 to generate $15000 after-taxes.

After-tax income = Pretax income x (1 – marginal tax rate)

15000=Pretax income ×(1-0.15)

Pretax income =$17,647

d. This strategy will save Tawanna $7353 pretax ($25000 - $17, 647). Tawana pays her son ($17,647). This saves Tawana $7059 in taxes because the payment is deductible ($17647 x 40%).

Her son receives $17647 . This costs her son ($2647) in taxes because he must pay tax on the compensation ($17647 x 15%).

Total savings is $4412 ($7059- $2647).

The after tax savings are the result of shifting $17647 of income from Tawana to her son. As a result, the family unit is paying taxes on the $17647 at 15% instead of 40%.

$17647 x (40% -15%) = $4412 after tax savings.